How the Bank broke the Government
By letting a rickety asset class grow like topsy, the Bank of England created the crisis blamed on the mini-budget
This is an exclusive preview of The Critic’s Christmas issue out next week! You can subscribe here.
George Soros is widely known as the man who broke the Bank of England. As we will see, the Bank is quite capable, advertently or inadvertently, of breaking governments.
The brutal demise of the Truss administration following the mini-budget has been widely attributed to the market’s reaction to the expectation of unfunded borrowing occasioned by tax cuts and the fuel price cap. To the contrary: the market’s behaviour was quite clearly a response to the actions — and inactions — of the Bank of England, before, during and after the mini-budget.
One part of, but not all of, the case against the Bank has been cogently made by Narayana Kocherlakota, a well-respected economist and former president of the Federal Reserve Bank of Minneapolis, in a Washington Post piece entitled “Markets didn’t oust Truss — the Bank of England did”. Kocherlakota’s view was that the Bank of England was responsible for the crisis, through “poor financial regulation and highly subjective crisis management”. Outside the UK chatterati, this view is widely supported.
The beef against the mini-budget was that it spooked the market. But virtually all of the policy announcements made by Kwasi Kwarteng on the day were not new; they had been pledged during the Truss campaign or — in the case of the energy price guarantee — confirmed shortly after her arrival in Downing Street.
Sure, the mini-budget stated that clarifying how all the spending/lowered tax revenue would be paid for was to be put off until the later financial statement, due some weeks later. But the only new thing was the change to the top rate of income tax from 45 per cent to 40 per cent.
Given the well-known dynamic impact of lowered tax rates, this change would arguably have been revenue neutral or even beneficial; even without any dynamic benefit, it could have cost at most £2 billion in tax revenue. That is a rounding error compared to the amounts already absorbed by the market and a fraction of the costs Rishi Sunak has accepted at COP 27 — to which the markets have reacted entirely complacently. It is just not credible to blame the mini-budget for the market turmoil.
And yet the gilt market spiked, spectacularly; sterling was under pressure and the narrative sprang up that people wouldn’t be able to get new mortgages, nor be able to service existing mortgages when their mortgage payment rate came to be recalculated. All this was gleefully blamed on the mini-budget.
So why did bond yields spike so suddenly? The missing link in the story is the peculiar, some would say unpardonable, actions of the Bank of England, in particular its failure to understand, and respond to, the increasingly dangerous behaviour of a large sub-sector of Britain’s pension funds, the so-called Liability Driven Investment funds (LDIs).
The prime obligation of a pension fund is to match its assets (the money it uses to make payments) to its liabilities (the payments it expects make to its pensioners over the years). For a fund to be as sure as it can that it will be able to pay its future pension liabilities, it buys assets whose coupons and maturity match its (actuarially expected) future pension payments.
So far, all well and good. The problem is with LDI funds. These, like so many pension funds these days, use gilts to accomplish that matching (in a popular meme of the past couple of decades, “gentlemen prefer bonds”). However, in addition the idea has been sold that they can goose up their returns a bit, to compensate for the low yields they are getting on their gilts.
This little bit of extra profit is accomplished by borrowing some further money, short-term, and with it buying long, higher-yielding assets — either real assets, or derivatives. It’s a well-known and always risky bet on interest rate movements; in some markets it’s known as the “Carry Trade”; in the Japanese markets it’s known as the “Widow Maker”. It’s entirely inappropriate for “safe” pension funds.
If rates move against the bet, the bet sours. To cover the risk they are taking, the funds are required to give over their other assets (the gilts) as collateral to the bank that lent them the money.
When the bet sours, the bank that lent them the money “calls the collateral”, selling off the gilts in order to repay the borrowing. Many would say that self-respecting pension fund trustees should never agree to take such risk, making the gilts simultaneously do two separate things: firstly serve, appropriately, as a well-matched future cash stream to service future pension liabilities — but secondly, to be collateral in the hands of lenders, who will sell them the moment interest rates rise and the gilts commensurately drop in value. If that happens, a wave of such sales can destabilise the gilts market and create a disorderly environment, as happened in late September 2022.
Some would say that the Bank of England should have known all of this and not allowed such risk to be taken by this huge market in LDI funds. Some would raise an eyebrow at the news that until the middle of 2022, the Bank of England itself held 100 per cent of its £5 billion pension fund in just one single LDI Fund, and therefore blithely seemed to believe it was OK for such risks to be taken (their 100 per cent recently was reduced to a scarcely less concerning 82 per cent).
For whatever reason, the Bank and other regulators did allow LDI funds to become more and more the fashion. But when markets move against these funds, there are suddenly a large number of players seeing their lender forcefully close their positions, selling their gilts collateral. The total value of liabilities hedged with LDI strategies was $1.8 trillion in 2021, around half of the total of LDI funds in the world, a sure sign that the Bank Of England had been far too lenient in allowing LDIs to flourish in the UK. That is Strike One.
Why then did the LDI funds start collapsing specifically in late September? It starts with the rapid appearance this year of inflation, caused in no small part — as the Bank has finally admitted — by the bank’s excessive growth of the money supply in recent years. As inflation consequently shot up, so, all year, did gilt yields rise, putting increasing pressure on those rickety LDI funds. That is Strike Two against the BoE for its role in worsening inflation in the UK, leading to this instability.
And then — two days before the infamous mini-budget — the Bank did two things. Firstly, it indicated that it was going to be soft on inflation by only raising rates by 50 instead of the expected 75 basis points. Saxo Bank, anticipating that this might happen, commented a few days before: “If the BoE fails to hike 75 basis points, let’s shield our eyes for what is going to happen to the pound here.” (They were predicting a fall in sterling, which duly happened. Low sterling leads to higher inflation leads to higher gilt yields.)
A week earlier, Deutsche Bank analysts had said that next week’s BoE meetings were critical for the currency and that a “hawkish turn” was needed, with the pound subject to extreme dislocation if the BoE did not step up its response. Both Deutsche and Saxo were right. Only days after the Bank failed to step up to the 75 basis points mark, sterling momentarily dropped to $1.04, just as Deutsche had predicted — yet for reasons that remain to be explained, the drop was blamed on the mini-budget, not on the Bank’s failure to sufficiently raise rates. The failure to raise rates enough, two days before the mini-budget, is Strike Three.
Secondly and simultaneously, however, the Bank doubled down by also announcing that it was moving from Quantitative Easing (QE) to Quantitative Tightening (QT) — it announced that it planned to sell a huge £40 billion of gilts into the market over the coming days.
Reuters emphasised the unusual nature of that announcement: “Bank of England set to become first big central bank to sell QE bonds.” Bloomberg said: “BoE to take Historic Step” — but it was much more than just historic. In 2013, all it had taken was the Fed to announce it was doing less QE — not stopping, just doing less — for the markets to go into a “Taper Tantrum”.
Ever since, most central banks have been cautious not to move too fast in shutting down their QE. But not the BoE. Why did it see itself as in a position to be the first in the world to take this very risky step, aware as they were that the mini-budget was about to be announced?
There was a reason other banks had not moved so quickly.
There was a reason other banks had not moved so quickly. When the central bank says it’s going to be selling bonds, market participants move fast to get ahead: they quickly sell their own bonds before their value is hammered by the BoE sales. Yields immediately go up and the price of bonds immediately falls. Which is why it was — Strike Four — stupid for the central bank to announce its moves ahead of time: it’s like the time that Gordon Brown announced he was selling all our gold, and the price collapsed so he made much less from the sale. But now the LDI pension funds started to get really hammered: as the market moved to dump gilts, the price of gilts fell and fell — this is still before the mini-budget — and collateral calls began to come thick and fast on the LDI funds.
What happened then? Why, more gilts were of course sold, to satisfy the collateral calls. And the value of gilts fell further. And even more collateral calls then came in, and we were in an accelerating doom loop. All this was happening as the mini-budget was announced, and the lazy financial press, not seeing what had happened earlier, blamed the rout in the gilts market on the mini-budget. But it was started by the Bank of England’s earlier decision to go full tonto QT. Strike Five.
Cue chaos in the markets. Yields go up from 3 to 4.5 per cent; sterling temporarily collapses. The Prime Minister is accused the following day of destroying the economy. The Bank of England, of course, immediately announces that it is not after all going to sell £40 billion of gilts — it is going to buy £60 billion of them — back from QT to QE in a blink of the eye.
But by now the gods of havoc have been unleashed. Truss’s enemies in the Conservative party get to work, using the mini-budget narrative to undo the mini-budget, to oust the Chancellor, and finally to oust the Prime Minister herself. Job Done.
No doubt we can in part blame the abrupt nature, and lack of rolling the pitch, of the mini-budget, but the lion’s share of the blame falls on the Bank of England — for allowing LDI funds to grow unregulated like Topsy, worse than anywhere else in the world; for growing the money supply to fuel inflation; for failing to show aggressive enough rate rises to curb inflation; for an abrupt, too-soon, world-first leap into QT.
We could add, to that, the fact that the Bank’s own pension fund of £5 billion was in LDI. Did this create a perverse incentive to go easy on LDIs? The fact that the Bank was so heavily invested in one asset class makes one wonder how well its officials understood the market they were meant to monitor. (We can also point out that you, dear reader, as a UK taxpayer, are putting a further £190 million every year into that Bank of England pension pot, to fund the marvellous Defined Benefit Pensions that all those masters of money will enjoy in their retirement, regardless of whether their LDI fund collapses or not.)
The post-mortem speech by the Bank’s director for financial stability, entitled “Risks from leverage: how did a small corner of the financial industry threaten financial stability?” makes for interesting reading; in this telling, the Bank staved off a crisis from what, for anyone, would have been an unexpected direction, dealing more than adequately with the non-bank sector. If anything, the director claims, the UK was ahead of the curve! An intriguing view. Equally intriguing is the fact that George Osborne and Rupert Harrison, late of BlackRock, the UK’s second largest provider of LDI funds, are now advising the new government.
The current governor of the Bank, Andrew Bailey — I am told nicknamed “Lullaby” by his colleagues — should be all too aware of this dynamic, coming as he does from a background in financial regulation. As head of the Financial Conduct Authority from 2016 to 2020, he saw first-hand the sort of shenanigans firms and funds will get up to if, pressed by smooth talking salesmen, they are given the freedom to act as they will.
It has been alleged that while in that role, Bailey “dozed off” during meetings over a pensions scandal. Now, the organisation he runs is accused of being asleep at the wheel on LDI pension funds, not to mention on inflation, the currency, the stability of markets. All that led to the end of a government, in a way that will continue to reverberate, to the detriment of many people’s view of democracy in this country, for decades to come.
Enjoying The Critic online? It's even better in print
Try five issues of Britain’s newest magazine for £10Subscribe